Still Unbalanced, by Tim Duy: The recent flow of data is interesting to say the least. While headline numbers are generally solid, the underlying story looks shaky. Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets. The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten. In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular. Yet we persistently fall short of a perfect world. Will this time be any different? The Greek crisis is saying it won't.

Manufacturing remains a clear bright spot in the economic environment, a point reiterated by the most recent ISM survey. The headline 60.4 was the strongest since 2004, and the underlying details were solid. Employment continues to expand, providing at least a modicum of relief for the beleaguered labor market. The inventory drain became apparent, with more firms than not reporting stockpiles as too low. This suggests further room for manufacturing expansion. The proportion of firms reporting rising prices edged up again, not unexpected considering the complete lack of pricing power and drop in commodity prices at the low point of the recession. Note too that the strength in the ISM numbers is consistent with the solid manufacturing report, with a strong gain in new orders for nonair, nondefense capital goods.

Although the positive tenor to manufacturing is welcome, the first quarter read on GDP reveals a more uneven pattern of recovery, and more worrisome, a recovery that looks a little too dependent on US households. Consumer spending gained 3.6%, contributing 2.55 percentage points to the headline 3.2% gain. The sustainability of such spending, however, remains in doubt. Note that spending growth was heavily supported by falling savings rates, while income growth less transfer payment remains stagnant. This suggests that consumers are once again leveraging up the balance sheets while the deleveraging outside of housing was likely not as deep as initially believed, once bank loan write-offs are accounted for. In short, it looks like we have come full circle. The US economy is again excessively dependent on consumer spending, and that spending is fueled by anything but organic income growth.

The next largest contributor was inventories, which add 1.57 percentage points - clearly part and parcel of the manufacturing revival. Also supportive of that sector was the 13.4% gain in equipment and software category, down from the previous quarter. But a closer look reveals that category, a small part of overall spending, contributed only 0.83 percentage points to growth, and the bulk of that was information technology; industrial and transportation were basically flat. Residential and nonresidential structures were both a drag on growth, illustrating the ongoing weakness of both sectors - weakness that prevents a true V-shaped recovery. Growth, yes, and even sustainable growth. But growth that leaves the economy limping along, heavily dependent on policies to stimulate consumer spending.

With overall investment still falling short of fully supportive of recovery, attention turns to the export story. And, yes, export growth is supportive. The problem is the import drag swamped the export push, leaving the external sector a net negative for growth, sapping 0.61 percentage points from the headline number. This drag throws a wrench into hope that external growth will support the recovery or a rebalancing of global activity. We need to acknowledge the possibility (likelihood) that outsourcing during the past twenty years has left the US structurally dependent on trade deficits. Fueling consumer spending simply translates into a substantially offsetting import increase, thereby preventing the external sector from contributing to growth on net.

Presumably, what we need is policy supportive of a real rebalancing, in which the US consumer is comparatively subdued, keeping a lid on import growth, while the rest of the world is firing on most cylinders. And here is where exchange rate adjustment is important. Faster growth abroad should translate into higher foreign interest rates, which should in turn be Dollar negative. Part of that story is in play. From the Wall Street Journal:

Prices across Asia are rising faster than expected, highlighting the region's strong recovery compared with the West and raising the likelihood for tighter monetary policy.

South Korea and Indonesia reported higher-than-expected inflation Monday, coming a day after China raised banking reserve requirements in a bid to cool its economy. In a sign that inflation is becoming entrenched, core prices, which exclude volatile food and energy, are ticking up.

Meanwhile, the Fed last week reiterated its commitment to ultra-low rates, which should come as no surprise given the uneven and inventory cycle dependent nature of US growth so far - note that real final sales posted another anemic reading of 1.6% in the first quarter. There is simply not enough growth to rapidly alleviate stress in the labor market, thereby keeping disinflation in play. The March read on core-PCE inflation confirmed the downward trend:

A declining Dollar is the signal to shift production to US shores and alleviate inflationary pressures abroad (while stimulating such pressure domestically), thereby limiting the need for foreign monetary policymakers to hit the brakes so fast that they stifle growth. There is no such thing as immaculate adjustment; a Dollar decline is critical to this process.

It should be a nice, textbook story. Alas, the US external adjustment is anything but textbook. The challenges I see to this adjustment:

Export supporting foreign policymakers. Foreign policymakers could attempt to simply shift demand away from internal sources and to the US by raising rates while accelerating reserve accumulation (and sterilizing the subsequent domestic money growth). Indeed, emerging Asian nations would be hesitant to hobble their exporting industries, more so if China does not first revalue the renminbi.

The Greek crisis. The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept. That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process. Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation. Which suggests the Euro has further to fall. But it is reasonable to believe that, given the German weight in the Eurozone, any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust. Are we really down to just two choice then? Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks? Both suggest a weaker Euro, but the latter points to an outright collapse.

The size of the Dollar adjustment. Given the substantial fixed costs of offshoring, it is possible that very large adjustments in the Dollar are necessary to give a lift to importing competing industries in particular. Policymakers may not have the stomach for such an adjustment, resulting in a slow pace of Dollar decline that the support provided net growth is almost negligible.

The dependence of everyone on the US consumer. Any rebalancing requires the importance of the US consumer to decline from the current 71% of US GDP. Yet US officials welcome the consumer recovery, and would be hesitant to accept renewed consumer weakness without a clear offset (which they could provide via increase public investment, if they wanted to). And foreign officials, faced with a political class of exporters dependent on US consumers, would be hesitant to risk angering that constituency with a substantial adjustment (see point 1 above).

These are challenges, and are not meant to imply that adjustment cannot occur. Only that so far that recovery has seen precious little such adjustment, with net exports subtracting from growth two of the last three quarters. The combination of tepid US consumer growth, rapid foreign growth, and a steady although not disruptive decline in the Dollar - the combination of factors that present in 2006 and early 2007 - appears difficult to achieve and sustain. I fear it requires a much more substantial global commitment to rebalancing than we have seen to date. And that commitment will be sorely lacking given the Greek crisis. Where the American-led financial crisis forced global policymaker to pull together, the European crisis may push them back apart.

Is it true that small businesses account for most of the growth and cyclical variation in net job creation? Small firms are an important and stable component of job growth, but most of the cyclical variation comes from large, existing firms:

One of the themes emerging from this literature is that focusing just on firm size misses an important aspect of job creation and destruction in the U.S. economy—namely, the interaction between firm size and firm age. To illustrate this, the following chart is a dissection of the U.S. Bureau of Labor Statistics (BLS) quarterly Business Employment Dynamics (BED) data into private employer firms with fewer than 50 employees and those with at least 50 employees (note that the BED classifies businesses using a dynamic size measure in which the job creation/destruction is allocated to a size class dynamically as a business moves through a size class from prior quarter to the current quarter). Within each firm type it is possible to allocate net employment change accounted for by opening firms (firms that had zero employment in the previous quarter), closing firms (firms with zero employment this quarter), and the net job change at surviving firms (employment at firms that expanded over the quarter less employment at firms that downsized over the quarter).

The contribution of opening small firms to net job growth is very large (averaging about 1 million jobs a quarter). In fact, when opening firms are netted out of the data, existing firms on average destroy more jobs than they create.

Job creation at new firms has been relatively stable over time. During the recessionary period from the end of 2007 through the second quarter of 2009, the decline in jobs created at opening firms was surprisingly small.

Job losses at closing firms did not surge in the most recent recession. In fact, job destruction caused by closing firms is relatively stable over time (research suggests that, in addition to the fact that many firms get smaller before they finally close, there is a significant "up or out" phenomenon in that many firms that closed were recently opened firms that failed).

Most of the cyclical action is at surviving firms, and larger surviving firms tend to account for most of the variation in net employment change. During the recessionary period from the end of 2007 through the second quarter of 2009, surviving firms with at least 50 employees lost about twice as many jobs as firms with fewer than 50 employees (see for example, the study by Moscarrini and Postel-Vinay on the relative cyclical sensitivity of large and small firms).

Of course, this is largely an accounting exercise. The challenge is trying to understand the causes for these features, and how they may change over time. It seems that there is much we don't know about the underlying factors. For instance, this paper by Dane Stangler and Paul Kedrosky investigates in considerable detail the possible explanations for why the number of new firms is so stable over time. In the end, the phenomenon remains largely a puzzle, and there are many subplots. For instance, the correlation between venture capital spending and overall firm creation is negligible but very important in high-tech industries. Also, the dramatic increase over time in the number of entrepreneurship courses offered at colleges and universities had no appreciable impact on the number of new firms in the United States (although it may have prevented a decline).

Perhaps the focus on the number of new firms is misguided. What really matters might be who these new firms are—not how many there are. Research by Dane Stangler suggests that, at any point in time, a relative handful of high-performing companies account for a large share of job creation and innovation. This conclusion suggests that a key to long-term economic growth may lie in ensuring that the economic environment is conducive to the ongoing creation of these types of high-growth performers.